Last week I wrote a comment (see here) at Save Capitalism (or, ‘Things we lost in the fire’), saying that I don’t expect the US to get into hyperinflation or default mode. I still believe in what I wrote, but I have had some thoughts about how the things could happen the way Save Capitalism described them.

Recently the Fed announced that it wants to keep the mortgage-backed securities (MBS, a.k.a ‘toxic waste’) and use the proceeds to buy government bonds. Now the Fed is pushing up bond prices, as investors happily buy bonds, knowing that they can sell them to the Fed afterwards. The US Treasury is surely going to use this ‘once in a lifetime’ opportunity to sell new bonds at record low interest rates.

However, I’m afraid there is one big problem coming up. What happens if inflation expectations go up, due to increased consumer demand and less than expected output gap, let’s say. The Fed always promised to mop up the excess liquidity in that case. But that would mean selling back the MBSs to the banks, the same banks that had to get rid off them 18 months ago because they couldn’t bear the losses. The housing market is still in shambles, so the MBSs shouldn’t be worth a penny now.

Furthermore, investor demand for government bonds now includes their demand for cash, since the Fed made clear that they are going to buy the bonds from the market. When investors now buy bonds, they do so in order to sell them to the Fed and get cash in exchange. Of course, demand for cash holdings would decrease, if inflation rates went up.

In that case, if the Fed wanted to prop up bond demand and draw out excess liquidity at the same time, they’d have to sell the MBSs at a faster pace than buying the government bonds. Within a year, all MBS would be back on the banks’ balance sheets, and the banks would again be impaired in their lending ability by potential/sure losses on those MBS. It would be October 2008 all over again.

The other option for the Fed would be to keep the MBSs as long as the housing market hasn’t somewhat recovered. However, the recovery in consumer and investment demand will probably happen much quicker. So the inflationary pressures will be already there, when the Fed still can’t shrink its balance sheet, if it doesn’t want to let the bond market go belly up. As a consequence, the Fed would have to fight a trade-off between stabilizing the bond market and stabilizing inflation rates. And guess what, this really isn’t a trade-off at all! If the Fed didn’t do enough to stabilize inflation rates, bond prices would go down as investors would demand higher interest rates on bonds. So the bond market would collapse no matter what the Fed actions are. You can imagine what that would mean for the credibility of the Treasury to finance its huge debt burden. Big Fat Greek Disaster!

All it needs to let this catastrophy happen is sufficiently rising inflation rates. I don’t know whether that will happen; nobody knows. My gut tells me that we won’t have high inflation rates for many years to come. Just compare our situation today with that of the Great Depression aftermath 1933-1939, and you’ll see what I mean.

Nevertheless, as I have shown you now, the Fed and the Treasury take huge (unnecessary) risks with their Quantitative Easing program. At this point now, it would be better for the Fed to end Quantitative Easing, to give the banks their MBSs back, and to make sure that the housing market gets the Slam Dunk Stimulus, so that it finally recovers, together with the MBS prices. Of course, that’s an advice for what could be done now, not what, in my opinion, should be done! I’d end all stimulus programs and other interferences into the economy and let some banks choke on their MBS. Call me a ‘deflationist’.

PS: This post at zerohedge.com tells a similar story. There, a spike in commodity prices is thought to set off a chain reaction similar to what I describe above. Well, I don’t think that commodity price rises can do the trick. In an ‘oil shock’ scenario (due to a war, let’s say), investors will buy bonds because the economy would be expected to tank and inflation expectations would stay put, as everybody would know that the rising prices are only temporary. I think it needs rising inflation expectations to set off the chain reaction, because expectations are what is priced into bonds.